By Steven K. Beckner
(MaceNews) – San Francisco Federal Reserve Bank President Mary Daly said Tuesday that monetary policy is “in a good place” presently, but said the Fed could decide to extend the maturity of its asset purchases if necessary – for example if it decided that long-term interest rates were moving too high.
For now, though, Daly said she views the increase in bond yields and in inflation breakevens as “positive” and part of “normal recovery dynamics” as she talked to reporters following a speech to the Economic Club of New York.
Daly, a 2021 voting member of the Fed’s policy making Federal Open Market Committee, said she is open to using yield curve control as a policy tool, but said there are potential drawbacks.
Elaborating on her earlier prepared remarks, in which she said the FOMC must exercise “patience” in pursuing its “maximum employment” and 2% average inflation goals, she said echoed the FOMC policy statement and said, “It’s very clear we are not going to react at the first hint that inflation might have breached 2%,” because “that could be very transitory.” The FOMC wants inflation to “overshoot for a period of time” to achieve 2% average inflation and “to make sure we hit our 2% goal.”
Similarly with the maximum employment mandate, “We wouldn’t just look at the fact that unemployment may have come down,” because that could occur because of reduced labor force participation.
“So patience is really used to describe the current statement we have out,” she said, adding that patience implies an “ability to sit through small spikes of data that seem like they’re signaling progress.”
“We’re going to have to have a big dose of patience in the summer,” she said, because inflation could well rise above 2%, but this would likely be “short-lived.” The FOMC will be “looking at the underlying inflation rate” and “looking at all measures of full employment.”
Daly’s implication seems to be that the FOMC will have to look through much of the data and keep monetary policy in its current ultra-easy stance.
Asked whether monetary policy is creating asset price “bubbles,” she said some prices are “elevated more than they have been historically, and that’s something to watch.” But she added, “it’s not something that would drive policy decisions.”
Daly seems to be paying more attention to the bond market, where yields have spiked since the year began, although the 10-year note yield has retreated about 20 basis points from last week’s high.
She said higher bond yields are “just pricing in a brighter future” and are “a good piece of news.” And she said they show “policy is in a very good place right now.”
Asked by Mace News whether the Fed might resort to yield curve control and whether it might adjust the composition of its balance sheet if long-term interest rates resume climbing, Daly replied that, “We do have the ability to push down the long end as we did with QE … . That’s something we can do by changing the maturity of the purchases we’re making.”
She added that the Fed could use yield curve control.
“These are all things we think about on a regular basis,” she went on but, “right now I’m very satisfied with where policy is.”
Elaborating, Daly said there has been “a notable improvement” in how market participants see the economic and policy outlook.
“It (the rise in yields) doesn’t surprise me … to see yields rising at the long end,” she said. “That makes sense, right. People think we’re going to execute on the framework. All this looks like normal recovery dynamics.”
“I think markets do get it,” Daly said, referring to a chart showing rising inflation expectations. “Market participants think we’re going to get to 2%… and we’re still below levels we’ve seen in past periods.“
“So I don’t judge this going up as a negative sign,” she said. “I judge it as an incorporation of the environment they’re observing, but also the understanding that the Fed is not going to stop inflation before it hits two. I see this as a real indication that they don’t think we have a 2% ceiling. They think we’re going for average inflation targeting.”
However, she allowed for a change of perspective. “Should monetary policy become less accommodative than we think appropriate we do have these other tools, including changing the composition of asset purchases.”
In deciding whether to use yield curve control there are a number of things the FOMC would have to consider, Daly said.
“You can only control one thing – price or quantity,” she explained. “So the way you do it with the balance sheet policy we’ve had so far is that we control the quantity of purchases and it filters through to give the pricing we want across the yield curve. So you’re controlling the quantity.”
“If you go to yield curve control, you’re controlling the price and the quantity is the free variable,” she continued. “So if you worry about the size of the balance sheets for all kinds of reasons, ranging from the mechanics of how markets work to the optics of a large balance sheet, whatever your interest is, if you lose control of the balance sheet size, then you’re saying you’re indifferent to those outcomes.”
“It’s not that I judge them to be more or less costly at this point, but I think we have to be serious in considering that you can only control one variable – price or quantity,” she went on. “So you have to pick which one you want to control by figuring out which one has the most target efficiency in terms of getting the outcome you want, which is accommodative monetary policy.”
“The other thing you have to think about it is if you let price go what is that outcome? If you let quantity go what is that outcome?”
“So far, and I always remain open-minded and studious, right now when I look at the literature … I see there are lot of advantages to using quantitative easing policies, like we used before in Operation Twist, as a first tool, but I’m not discounting yield curve control should we find that it’s a more appropriate or target-efficient policy.”
Earlier, in response to webinar questions, Daly disputed warnings that further fiscal stimulus poses an inflation threat, saying federal deficit spending is just providing a “bridge” to economic recovery and countering a “demand shock.” If anything, she said more inflation would be welcome.
“If inflation rises in ways that are detrimental we can pull it back,” she added.
Daly said her “modal outlook” is for a second half bounceback similar to the one the U.S. economy experienced last summer. If that doesn’t happen, she said she will adjust her forecast.
Asked about long-term labor market “scarring” from the pandemic, Daly said the experience of the recovery from the financial crisis shows that people will come back into the labor market if the recovery is sustained long enough.
The lessons, she said, amounts to, “Let’s put as much (monetary and fiscal stimulus) into the cyclical bucket as possible.”
In her earlier prepared remarks she said Tuesday the Fed needs to pursue its redefined employment and inflation goals with “patience” and leave monetary policy easy “for some time” in what she called a “new normal” economy.
Daly, a 2021 voting member of the Fed’s policy making Federal Open Market Committee, welcomed the recent rise in inflation expectations, and dismissed undue “fear” of excessive inflation in a speech to the Economic Club of New York.
Daly contended the Fed is operating in a new environment – “a new normal” – in which concepts like the Phillips Curve trade-off of unemployment and inflation and the non-accelerating inflation rate of unemployment (NAIRU) no longer apply and in which low inflation expectations and low real interest rates have pressed the central bank against the zero lower bound for its policy rate, the federal funds rate.
The Fed faces a dilemma, she suggested. “We must work to return the economy to full employment and price stability,” she said. “This is a tall order; millions of Americans are out of work and inflation remains well below our target.”
“At the same time, a swell of market and academic commentary has started to emerge about a quick snapback, an undesirable pickup in inflation and the need for the Federal Reserve to withdraw accommodation more quickly than expected,” she continued.
Daly called such concerns “the tug of fear – the reaction to a memory of high and rising inflation, an inexorable link between unemployment, wages and prices, and a Federal Reserve that once fell behind the policy curve.”
“But the world today is different, and we can’t let those memories, those scars, dictate current and future policy” she added.
Daly acknowledged “there is still some level of unemployment below which wage and price inflation will pick up,” but said, “it’s hard to know, a priori, where it is.” Besides, “the dynamics of inflation have also changed. Inflation is far less responsive to movements in output and employment than in previous decade.”
She said these factors “are likely to continue to persist in the coming years, requiring us to adjust our policies to adapt to the new environment.”
What’s more, Daly said the real neutral rate of interest (r*) is apt to stay not far above zero “for some time” and said “in this world, keeping inflation expectations well-anchored at 2% will be essential.”
“Any drift down (of inflation expectations) translates into lower inflation, a lower nominal funds rate, and fewer rate cuts when the economy needs them,” she warned.
Given all those considerations, Daly said the Fed “will face an uphill battle using conventional monetary policy to keep the economy healthy, the labor market strong, and inflation at our 2% goal.”
Echoing the new policy framework which the FOMC implemented last fall, she said “in the absence of inflationary pressures, we will not pull back the reins on the economy in response to a strong labor market.”
As the Fed seeks “broad and inclusive” “maximum employment,” she said the FOMC “will examine a wide range of indicators – measures like unemployment, labor force participation, job finding, and wage growth – across a broad distribution of workers.” And Daly added, “As we apply this strategy, our most important virtue will be patience.”
“We will need to continually reassess what the labor market is capable of and avoid preemptively tightening monetary policy before millions of Americans have an opportunity to benefit,” she elaborated.
At the same time, the Fed must “ensure that inflation expectations remain well-anchored at 2% … . This approach helps put a floor under inflation expectations, enhancing our ability to achieve our full employment and price stability goals.”
“Practically, the new framework allows us to retain our vigilance against inflation that is too high, while improving our ability to keep inflation from falling too low,” she said.
With the pandemic still exerting a drag on some sectors of the economy, Daly said “getting fully past this crisis and back on track to achieve our dual mandate goals will require monetary policy to be accommodative for some time.”
Scorning “the fearful swirl about spikes in inflation and the need to preemptively offset them,” Daly conceded.“We need to be vigilant against all the risks in the economy,” but she said, “we also must weight them by their likelihood and expected cost.”
“As for the likelihood of runaway inflation, I don’t see this risk as imminent, and neither do market participants,” she added.
Inflation expectations have risen steeply since the start of the year. The 5-year breakeven inflation rate, which began the year at 1.98%, rose to 2.40% on Monday.
Far from being concerned by the widening of the spread between regular and inflation protected Treasury securities (TIPS), Daly said she views it as “encouraging and in line with our stated goals. It suggests that our commitment to flexible average inflation targeting has already gained substantial credibility.”
If anything, inflation risks are to the downside, according to Daly. Compared to 1970s and ‘80s, “today, the costs are tilted the other way. Running inflation too low for too long can pull down inflation expectations, reduce policy space, and leave millions of Americans on the sidelines along the way.”
Earlier, Fed Governor Lael Brainard echoed the call for “patience” — invoked by Chairman Jerome Powell in two days of congressional testimony last week.
In assessing when the Fed has achieved “substantial further progress” toward its goals and can consider reducing asset purchases, Brainard said she “will be looking for realized progress toward both our employment and inflation goals.”
“I will be looking for indicators that show the progress on employment is broad based and inclusive rather than focusing solely on the aggregate headline unemployment rate, especially in light of the significant decline in labor force participation since the spread of COVID and the elevated unemployment rate for workers in the lowest-wage quartile and other disproportionately affected groups,” she added.
Brainard said she also “will carefully monitor inflation expectations,” but emphasized, “it will be important to achieve a sustained improvement in actual inflation to meet our average inflation goal.”
“The past decade of underperformance on our inflation target highlights that reaching 2% inflation will require patience, and we have pledged to hold the policy rate in its current range until not only has inflation risen to 2% but it is also on track to moderately exceed 2 percent for some time,” she said.
Brainard said the FOMC “will be vigilant” and she pledged that “ if, in the future, inflation rises immoderately or persistently above target, and there is evidence that longer-term inflation expectations are moving above our longer-run goal,” she “would not hesitate to act.”
But for now, she added, “the economy remains far from our goals in terms of both employment and inflation, and it will take some time to achieve substantial further progress.”
Noting that jobs are still 10 million below the pre-COVID level, and inflation has been running below 2% for years,” she reiterated, “We will need to be patient to achieve the outcomes set out in our guidance.”
Contact this reporter: steve@macenews.com
(This story was updated at 5:45p ET with comments from a Q&A session with reporters.)
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